Of Trade Wars and Growth
Trade wars – it is about much more than just the tariffs.
At the start of 2018, the outlook for emerging markets seemed extremely positive. A strong global growth environment and continued risk appetite from international investors were good news for emerging economies. In South Africa things were very encouraging. It seemed that the country’s change in political leadership and the potential for improved business and consumer confidence could see it benefit substantially from the continued appetite for emerging markets assets.
However, when President Donald Trump announced at the start of March that the US would be imposing tariffs on steel and aluminium imports, this picture began to change. When Trump added to these early in June with his announcement that the US would be placing a 25% tariff on $50 billion of Chinese goods, things grew even gloomier.
From what had been a positive global backdrop early in 2018, the environment in May and June was suddenly far less supportive. Uncertainty about where the US stance would lead and the potential for a trade war made investors internationally far less keen to take on risk, and therefore much less bullish on emerging markets.
It is of course impossible to tell the future and how far such a trade war may go. Presently we have a what may be called a skirmish - a lot of noise and warning shots. The $50 billion of trade that the US has put tariffs on already is a very small amount in the global trade picture.
Even though China and the EU are imposing retaliatory tariffs, these are significantly smaller than those the US has already approved. In an announcement on Friday 23 June 2018, the two imposed tariffs on $3.3 billion of American products.
The unpredictable factor is Trump. It is extremely difficult to judge what he will do. As he has shown with his approach to North Korea, highly antagonistic rhetoric can very quickly lead to conciliation. It may be that Trump’s threats of much greater tariffs are simply his way of forcing other countries to compromise, however one cannot discount that they may be genuine intentions. If they are the latter, then there really will be trouble.
If this escalates to tariffs on $200 billion worth of trade from the US side, then it becomes a real issue, and the retaliation is going be so much bigger from everyone else, and that will be a problem.
If this escalates to tariffs on $200 billion worth of trade from the US side, then it becomes a real issue, and the retaliation is going be so much bigger from everyone else.
The impact on gr
But it is not all about tariffs. Already it seems that the uncertainty is impacting global trade. Judged by the world container index, trade is still growing, but it has retarded from 4% to 1%. In fact, expected global economic growth may slow down. (Source 1)
In April 2018 the International Monetary Fund reported that the global economic upswing that began around mid-2016 has become broader and stronger. This World Economic Outlook report projects that advanced economies as a group will continue to expand above their potential growth rates this year and next before decelerating, while growth in emerging market and developing economies will rise before leveling off. For most countries, current favorable growth rates will not last. Policymakers should seize this opportunity to bolster growth, make it more durable, and equip their governments better to counter the next downturn.
World growth strengthened in 2017 to 3.8 percent, with a notable rebound in global trade. It was driven by an investment recovery in advanced economies, continued strong growth in emerging Asia, a notable upswing in emerging Europe, and signs of recovery in several commodity exporters. Global growth is expected to tick up to 3.9 percent this year and next, supported by strong momentum, favorable market sentiment, accommodative financial conditions, and the domestic and international repercussions of expansionary fiscal policy in the United States. The partial recovery in commodity prices should allow conditions in commodity exporters to gradually improve. (Source 2)
On 5 June 2018 The World Bank reported as follows: Despite recent softening, global economic growth will remain robust at 3.1 percent in 2018 before slowing gradually over the next two years, as advanced-economy growth decelerates and the recovery in major commodity-exporting emerging market and developing economies levels off.
Activity in advanced economies is expected to grow 2.2 percent in 2018 before easing to a 2 percent rate of expansion next year, as central banks gradually remove monetary stimulus. Growth in emerging markets and developing economies overall is projected to strengthen to 4.5 percent in 2018, before reaching 4.7 percent in 2019 as the recovery in commodity exporters matures and commodity prices level off following this year’s increase.
This outlook is subject to considerable downside risks. The possibility of disorderly financial market volatility has increased, and the vulnerability of some emerging market and developing economies to such disruption has risen. Trade protectionist sentiment has also mounted, while policy uncertainty and geopolitical risks remain elevated. (Source 3)
This is not good news for South Africa, which is trying to work itself out of years of poor economic performance. A strong global growth environment would be supportive, but weakness in the global economy would make it even more difficult for the country to accelerate its fortunes.
South Africa is also highly dependent on foreign investment inflows. However the uncertainty being created in the global environment has already shifted investor perceptions, with risk appetites diminishing significantly and emerging markets falling out of favour.
This is bad news for a country that relies on portfolio inflows to balance its current account deficit. The rapid weakening of the rand since the middle of May from R12.25 to the dollar to around R13.70 to the dollar is an indication of this.
An open economy like South Africa is extremely vulnerable. A falling rand also inevitably leads to higher inflation. This too is negative for the local economy. Around 60% of South Africa’s GDP is consumer spending, and rising prices depress consumer activity. If inflation climbs higher, that therefore takes away from GDP growth. The implications for South Africa are therefore likely to be largely negative. There is however one potential silver lining. Over the long term a weak ZAR should discourage imports and encourage exports.
Foreign selling of SA government bonds
During 2017 foreigners bought R55 billion worth of South African government bonds. In the first six months of 2018, foreigners were net sellers of R39.2 billion of SA government bonds. This is the first time, going back to the early 2000s, that the foreign holding of local government bonds fell in the first six months of a year. Considering South Africa’s reliance on foreign inflows to finance the shortage in domestic savings, the large selling is a concern and partly explains the weakness in the currency over the last while.
However, it is important to put this in context. While the scale of the selling is notable, foreigners still own around 40% of South African government debt. As the chart below shows, back in 2006, they owned just 8.6%.
There are three important things take into consideration when looking at the significance of the selling we have seen this year. The first is that while R39.2 billion is a big number, it is a small percentage of the total foreign holding. Since South Africa’s total debt has also increased substantially, it is also a relatively small portion of the overall market.
When foreign investors sold R19.5 billion of South African debt back in 2008, that was 5.3% of the total outstanding government debt. Year to date they have sold more, but it is a smaller percentage.
Secondly, local pension funds own a far smaller proportion of government bonds than they have historically. They have therefore been absorbing the foreign selling quite easily.
Many fund managers in the savings industry have been short on South African assets, but with corporate bond yields coming down those who have been short on government bonds are rotating back into the market. So, there is quite a bit of appetite for SA government bonds locally.
Relative to equities, government bonds are also looking the cheapest that they have for a while and many South African asset managers are therefore very comfortable increasing their allocations. Government bonds are still offering high real yields. Ten-year bonds are yielding around 8.8% now and with inflation at 4.4% that means you are earning a real yield of more than 4%. That is a good opportunity from a management perspective.
The third important consideration is the broader global context in which the sell-off is happening. In February and March, foreigners were net buyers of local bonds. April was neutral, so it is only in the last two months, May and June, that concerns have grown around emerging markets and that a potential trade war have reversed sentiment. The sell-off has therefore not been about the idiosyncrasies of South Africa’s fiscal outlook. Foreign investors are more concerned about what is happening in emerging markets as a group.
Further, this is very apparent if one considers that the scale of the selling over the last two months is much larger than at any point in 2017 when there were real concerns about South Africa’s fiscal stability and the threat of government bonds being downgraded to sub-investment grade. This also makes it likely that the market may stabilise in the near term.
There are already signs this may be happening. If one looks at the yield on 10-year bonds, it increased to 9.20% at its peak, but has come declined back to 8.75%. So more broadly, the selling has impacted bond yields, but the sentiment seems to have stabilized and the take-up on the local market has driven yields down again.
Unless there is a significant emerging market scare, the sell-off trend is unlikely to continue over the longer term. (Source 4)
So, Quo Vadis Equity Markets?
We begin with our, now infamous, famous graph of the JSE Alsi40 (below) over that last 60 months. As is clear from the graph this index was in a sideways channel from April 2014 to mid-June 2017. In the bottom block of the graph is the relative strength of the Alsi40 Index measured against the S&P500.
We know that there is a very long history of a strong co-movement of equity markets over the globe. During the period April 2014 to June 2017 it appeared as if the South African equity markets (as measured by the Alsi 40) have somehow lost its connectivity with world markets. The good news is that we have regained traction and since mid-2017 we have performed much in line with other markets. Measured from 1 June 2017 to 4 July 2018 the S&P500 delivered 11% return while the Alsi40 harvested 10.5%. Both numbers are sans a dividend and in local currencies. In dollar terms the Alsi 40 produced 16.9%
The year started of with a lot of optimism. But the current talk of trade wars has most certainly muted market exuberance and most decidedly in emerging markets. In this current environment we maintain a larger than average cash position in conjunction with very low exposure to non Alsi40 equities with our normal emphasis on quality international players. (Source 5)
Source 1: How a global trade war would hurt SA. Patrick Cairns . Moneyweb 26 June 2018.
Source 2. International Monetary Fund. World Economic Outlook. April 2018
Source 3: The World Bank. Global Economy to Expand by 3.1 percent in 2018, Slower Growth Seen Ahead. 5 June 2018.
Source 4: Foreign selling of SA government bonds. Patrick Cairns . Moneyweb 26 June 2018.
Source 5: FAL Research